Industry analysis provides a framework for understanding the firm.
Gives insight into potential growth, competition and risks.
Industry rotation = overweighting or underweighting industries based on the current phase of the business cycle
One way to group is by products and services they offer. If diverse use principle business activity
Another way to classify is by using sensitivity to business cycles. : cyclical and non-cyclical firms
Statistical methods: cluster analysis: group by historically highly correlated returns
- Limitation of statistical a) Historical may not be same as future correlations b) Grouping of firms may differ across time and countries c) Grouping of firms is sometimes non-intuitive d) Susceptible to statistical error
2. INDUSTRY CLASSIFICATION SYSTEMS
A) COMMERCIAL CLASSIFICATIONS Basic material and processing Consumer discretionary (hotels) Consumer Stales (food) Energy Financial Services Healthcare Industrial and producer durables (aerospace,defence) Technology
B) GOVERNMENT CLASSIFICATION International standard industrial classification of all economic activities (ISIC) Statistical Classification of Economic Activities in European Community Australian and New Zealand Industrial classification North American Industrial Classification system
Updated every five years, do not distinguish between small and large firms, profit or non- profit, public or private etc
3. FACTOS THAT AFFCET SENSITIVITY TO A BUSINESS CYCLE
Cyclical : earnings highly dependant on stage of firm in business cycle. High earnings volatility and high operating leverage Non-cyclical Demand relatively stable over business cycle
Non cyclical can be separated into
A) Defensive industries : Least affected by stage of the business cycle (food producers, drug stores) B) Growth industries: demand so strong that largely unaffected by business cycle
Non cyclical can be severely affected by recession and defensive may not be safe investments
4. IDENTIFYING POTENTIAL PPER GROUP FOR EVALUATION
Peer group: set of similar companies that an analyst would use for valuation comparison
- Firstly identify industry and commercial classifications
- Examine firms annual reports and identify key competitors - Examine competitors annual reports and look if they have key competitors - Confirm comparable sources have similar earnings and sources of sales - Adjust non-financial information for any financial subsidiary data
5. ELEMENTS THAT NEED TO BE COVERED IN INDUSTRY ANALYSIS
- Relationship between macroeconomic variables and industry trends using info
- Estimate industry variables using different scenarios and info
- Compare with other industry analysis from analysts
- Determine relative valuation of different industries
- Compare valuations to determine volatility of performance in the long run
- Analyse industry prospects based on strategic groups (complex delivery of services -hotel chains)
- Classify industry by life cycle stage
- Position industry on experience curve
- Consider Forces that affect industries
- Examine the Frye’s that determines competition within the industry
6. PRINCIPALS OF STRATEGIC ANALYSIS OF INDUSTRY
Economic profits = Return on invested capital – costs
Strategic analysis: how industries’ competitive environment influences a firm’s strategy
- Rivalry Among existing competitors : Slow growth leads to firms fighting for market share High fixed costs lead to price decreases as firms operate at full capacity
- Threat of Entry : : With higher barriers:easier to maintain premium pricing
Examples: costly to enter oil and steel production industries: large initial outlay Less competition. Economies of scale to be considered
- Threat of Substitutes. : Limit Profit potential by putting a cap on pricing by increasing
elasticity of demand. More differentiated products : less competition
- Power of buyers : Buyers ability to bargain for lower prices
- Power of suppliers: suppliers’ ability to raise prices. Microsoft = higher power
7. FACTORS THAT INCREASE COMPETITION
- Market fragmentation (less concentration)
- Unused capacity - Stability in market pricing= decrease competition = loyalty - More price sensitivity in customers buying
8. PRICING POWER AND COMPANY ANALYSIS
A) Barriers to Entry - Reduce chances of new competitors therefore higher market share and return on capital - However this does not mean pricing power as there may be high competition among existing competitors
B) Industry Concentration - Does not guarantee pricing power. - If undifferentiated products, customers choice will be the lower priced one
C) Industry Capacity - Clear impact on pricing power - Under capacity = , demand exceeds supply at current price = pricing power
D) Market Share Stability
- If market shares stable or variable. If variable then high competition - Factors that affect stability= barriers to entry, high switching costs, new products and innovation
9. INDUSTRY LIFE CYCLE
A) EMBRYONIC - Slow growth - High prices - Large investment - High Risk of Failure
- Macroeconomic : - Technology - Demographic - Governments - Social influences 11. IN THOROUGH ANALYSIS
- Analysing firms financial condition, products and services and competitive strategy - Two competitive strategies, cost leadership (low cost) (including predatory pricing- low price first then increase) or products services differentiation strategy - Company analysis should include a) Firm overview b) Industry characteristics c) Product demand and costs d) Pricing environment e) Financial ration, projected valuations
